Remember when a “cloud” was a fluffy white mass of crystallized water in the sky? Or “viral” referred to a case of strep throat? The words that make up our vocabulary are cosntantly changing and adapt new meaningings, sometimes distorting to the point where the original meaning is completely… meaningless.
Though we might look to social media as the most prominent stage for examples of etymological evolution, “semantic change,” as it is more commonly known, is a phenomenon as old as language itself. While for the most part, such mutations are harmless, for key industries where specific wording matters, use of outdated terms can lead to major issues.
“Outdated terms may lead to excessive risk taking and time wasted on short-term issues that have little or no bearing on pension plan success,” reads a press release from brokerage and advisory fiirm Willis Towers Watson. “These new definitions can help improve how sponsors, consultants and managers address pension plan challenges as we head into 2018.”
WTW has taken it upon itself to redefine 10 key terms commonly used in DB investment plans. For each term, the company offers a “traditional” definition, as well as its “modern” interpretation.
1. Fiduciary duty
Traditional: Actions taken are documented and reasonable.
Modern: Actions taken are subject to a higher level of scrutiny as more parties are considered fiduciaries and are being held to higher standards that require subject matter expertise.
2. Full funding
Traditional: Having assets that equal or exceed accounting liabilities.
Modern: Having assets that equal or exceed the organization’s desired funding target, which could reflect market cost required to settle obligations, signify the ability to run them off over the very long term, or support future benefits for employees.
3. Time horizon
Traditional: The very long period of time until the plan makes its last benefit payment.
Modern: A series of time frames that vary in length depending on sponsor objectives, plan liability profile and the desired approach to delivering retirement benefits over the long term (either through the plan or through settlement). In some cases, the time horizon can be very short.
4. Investment strategy
Traditional: The plan’s static asset allocation and investment manager lineup.
Modern: The dynamic process of achieving a series of risk allocations that vary with market conditions and reflect the plan’s progress toward its funding and settlement objectives.
5. Interest rate risk
Traditional: A financial risk to the plan sponsor that can result in significant gains or losses relative to the liability in the event that interest rate changes occur within the time horizon. Plans with interest rate risk often maintain a large and risky “short position” relative to the liability, potentially larger than other risks in their portfolio or even their core business.
Modern: A liability valuation factor where increases are already priced into the forward curve, meaning potential gains from taking this risk are lower than one might expect. It is often the most significant risk for pension plans, extremely difficult to time and vital to portfolio construction.
6. Liability-driven investing (LDI)
Traditional: Extending interest rate exposure of plan assets, primarily through longduration fixed-income investments.
Modern: Making any investment decision that takes the unique profile of the liability into account. This can extend beyond long-duration fixed-income assets as long as the decision was made to manage risk in an asset/liability context.
Traditional: Allocate across various regions (e.g., U.S., non-U.S., emerging markets), investment styles (e.g., value, growth, momentum), managers and asset classes in the portfolio.
Modern: Use a greater variety of return drivers to help enhance return and/or potentially reduce total portfolio risk. For example, look beyond traditional beta, alpha and interest rate exposures into the potential risk premia from illiquidity, complexity or difficult implementation. When new investment ideas arrive down the road, avoid constraining them with traditional asset-class buckets.
Traditional: Execution of investment ideas by a part-time fiduciary committee that meets infrequently.
Modern: Proactive, timely and transparent portfolio management and execution within cost and risk budgets. This is supported by a deep resource structure, internal or outsourced, that empowers committees to focus on their strategic goals for the pension.
Traditional: Outsourcing just your manager selection activity to a third party or outsourcing a whole lot more, including strategy setting.
Modern: Enhancing your ability to make strategic decisions and achieve strategic goals by outsourcing their execution to third parties. Delegation aims to improve efficiency of implementation, reduce costs and manage risks within the context of your defined investment strategy and allow you to reallocate resources toward your core business.
Traditional: Achieving the desired return, whether this is articulated as “manager outperformance of its benchmark,” “meeting a forward-looking target or hurdle rate,” or “beating peers.”
Modern: The ability to execute the firm’s objectives, including those related to funded status and risk management, and to ultimately secure benefits for all plan participants (via various combinations of obligation retention and settlement strategies). Oversight and monitoring of the strategy focuses on progress relative to objectives, with less emphasis on short-term investment return goals.